Constructing path for infrastructure development

The Securities and Exchange Board of India (SEBI) has approved new norms for issuance and listing of municipal bonds or Muni bonds on stock exchanges. The decision will help raise funds for infrastructure projects and the government´s smart cities initiative. The Municipal Bond Regulations have made an attempt to align the interests of the public with funding to the municipalities.

India´s projected urban population growth is estimated to be approximately 650,00,000 (six hundred fifty million) by the year 2050. This translates into accelerated demand for urban infrastructure facilities and services. Taking into consideration this burgeoning requirement for urban infrastructure development, it became imperative to assess whether the urban local bodies (ULBs) were capable of achieving the desired outcome. Financing for infrastructure development by municipalities has traditionally been met by revenue generated from local taxes. However, ULB tax bases are narrow, rigid, and lack dynamism as compared to that of the state and the central governments. In addition to taxes, ULBs depend on grants by the State and/or Central Government in order to fund projects. With the advent of ambitious infrastructure projects like smart cities, ULBs require a well-structured funding mechanism to support such development. The Securities and Exchange Board of India (Issue and Listing of Debt Securities by Municipality) Regulations, 2015 (the ´Municipal Bond Regulations´) aim to provide just that. The Municipal Bond Regulations have made an attempt to align the interests of the public with funding to the municipalities.

Municipal Bonds Genesis
In western markets, municipal bonds or ´Muni bonds´ are very popular among investors, especially in the US, where these bonds have amassed investments over USD 500 billion and are among preferred invest¡ment avenues for regular households. In China, municipal bonds claim to have attracted around USD 187 billion of investment.

The concept of municipal bonds is not alien to the Indian investment arena as well. Municipal bonds were issued with a state guarantee by the Bangalore Municipal Corporation as early as 1997. However, the access to capital market, by means of a public issue, commenced in January 1998, when the Ahmedabad Municipal Corporation (AMC) issued the first municipal bonds in the country without state government guarantee. AMC raised Rs 1,000 million to use in financing infrastructure projects. Various municipal bodies of cities like Hyderabad, Nashik, Visakhapatnam, Chennai, Ludhiana, Madurai, and Nagpur followed suit. The bond proceeds are generally utilized for small scale projects like water and sewerage schemes or road projects. Municipalities have so far mobilized only Rs 4,450 million from the domestic capital market through taxable municipal bonds. In a bid to give a boost to the municipal bond market in India, the Government of India (GOI) amended the Income Tax Act (1961 vide the Finance Act 2000).

Accordingly, the interest income from municipal bonds issued by local authorities was exempted from income tax. In February 2001, the GOI issued guidelines for issue of tax-free municipal bonds.

The aforementioned guidelines provide that funds raised from tax free municipal bonds are to be used only for capital investments in urban infrastructure for providing one or more of specified activities and that the proceeds of the proposed issue will be clearly earmarked for a defined project or a set of projects. The guidelines also lay emphasis on the financial viability of the project(s). However, due to lack of a regulatory framework for listing and subsequent trading of these municipal bonds on stock exchanges in India, the investor base never expanded and the potential investment remained untapped. The need to mobilise this base gained urgency due to the waning enthusiasm for public private partnerships (PPP) due to various systematic issues.

Recently, in October 2013, under the ´Corporate Bonds and Securitisation Advisory Committee´, (CoBoSAC) a sub-committee consisting of stake- holders and representatives of Ministry of Urban Development (MOUD), Ministry of Finance (MOF), and municipalities was formed to deliberate on different structures for issuance of municipal bonds by ULBs. In November 2014, an information memorandum on development in corporate bond market was presented. In light of the above, SEBI framed the draft Municipal Bond Regulations.

Salient Features of Municipal Bond Regulations Creditworthiness
Under the draft regulations, municipalities are required to obtain credit rating from at least one recognized credit rating agency registered with SEBI. In case of public issue, the ULBs or corporate municipal entities (CMEs). CME is a subsidiary, of a municipality, incorporated under the Companies Act, 2013 and is set up for the purpose of raising funds for a specific or multiple municipality. It is required to have a minimum investment grade rating.

As ratings are usually given based on various parameters such as economic parameters, legal parameters, financial parameters, administrative parameters, and most importantly, the viability of the project for which the fund is being raised - the ULBs or CMEs listing their securities or municipal bonds will be vetted. In addition to the credit ratings, in order to be eligible to issue and list municipal bonds, the municipalities should not have a negative net worth for the past three years and should not have default in the last 365 (three hundred sixty five) days on a debt from a bank or PFI .

The viability of the project would also be assessed as the ULBs or CMEs are required to obtain a ´viability certificate´ or Detailed Project Appraisal Report from a scheduled commercial bank or public financial institution (PFI).

Increased accountability
With a debt structure of funding, the municipalities have an obligation to repay, and with their bonds listed and traded across stock exchanges of the country, ULBs or CMEs would be pressed to prudently plan and execute projects that would result into optimum revenues, minimised O&M costs, and lead to steady surplus throughout the lifespan of an asset.

Further, disclosures are to be made in the offer document in accordance with the Companies Act, 2013 and SEBI regulations. This would also keep the entire process transparent and garner the trust of the investors.

Proper fund management
The Municipal Bond Regulations set out certain provisions, which provide assurance towards proper fund management. Utilization of the issue proceeds is to be only for the project(s) for which the debt securities were issued. A special project implementation cell is to be established and a project officer is to be appointed to ensure that the funds are only used for the specified purpose.

Investor centric
As mentioned above, several checks are in place in order to retain an investor´s confidence in the municipality issuing municipal bonds. Further, under the Municipal Bond Regulations, the debentures issued will either be fully secured or backed by a State Government or Central Government guarantee or have debt servicing mechanism. The municipalities issuing municipal bonds are required to maintain 100 per cent asset cover sufficient to discharge the principal amount at all times for the debt securities issued. Furthermore, the issuing ULB or CME is required to create a separate escrow account for earmarking revenues for repayment and such an account would be monitored by a PFI or nationalized bank.

Therefore, the Municipal Bond Regulations in a way guarantees returns to the investors, thereby increasing investment.

Lacunae
There are certain issues, which have not been addressed by the Municipal Bond Regulations. The Municipal Bond Regulations does not make the ULBs accountable for executing projects on time as per the schedule in order to avoid excessive overruns. Also, despite of the regulations and structured approach, due to the longer investment duration and lesser returns, the issuance of municipal bonds would attract low-risk investors, however, investors seeking higher returns may still shy away.

Conclusion
The inclination of Indian investment market towards municipal bonds can be gauged by the fact that Indian investors are usually conservative, preferring a mode of investment with minimum risk and moderate to high returns. Though corporate bonds generally have a higher yield, the risk involved is also higher. It has been seen that market fluctuations affect corporate bonds more than municipal bonds. Therefore, even though municipal bonds yield several percentage points below the yield on corporate bonds of comparable maturity , the low risk factor makes the bond more appealing to public in general. The perceived advantage is bolstered by the State guarantees that often back such bonds.

With the development of facility intensive infrastructure projects like smart cities, municipalities will have to branch out towards innovative modes of financing, financing beyond PPP, infrastructure bonds, grants, etc. SEBI with the Municipal Bond Regulations has initiated a progressive step towards structuring the underutilised finance mechanism of municipal bonds.

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DISCLAIMER: This article has been authored by Aakanksha Joshi, who is an Associate Partner and Ashlesha Galgale, who is an Associate at Economic Laws Practice (ELP), Advocates & Solicitors. They can be reached at aakankshajoshi@elp-in.com or ashleshagalgale@elp-in.com for any comment or query. The information provided in the article is intended for informational purposes only and does not constitute legal opinion or advice. Readers are requested to seek formal legal advice prior to acting upon any of the information provided herein.

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